3 Hidden Pitfalls Coming to a 401(k) Statement Near You
December 18, 2014When you see your 401(k) balance or even a projection of your future balance when you retire, do you really know what that number means for your retirement? If you’re like most people, you probably don’t. A $200k balance may look like the most amount of money you’ve ever had so you can easily think it will be more than sufficient even if it turns out to be nowhere near enough to generate the income you’ll need to retire comfortably.
One solution is to run a retirement calculator like this that can help you determine whether you’re on track. Your retirement plan provider may offer one too. But according to our latest research, only about 1/3 of employees have ever run a retirement calculation. That leaves a lot of people with no idea whether they’re on track.
To address this problem, there’s a new trend towards showing how much retirement income an employee is projected to have from their retirement account. While this can certainly be a huge improvement, there are a few reasons why this number may be misleading. Specifically, it can cause you to think you’re in better shape than you are. Here are 3 things you’ll want to keep in mind if you should see these income projections on your retirement statements:
1) They assume you will annuitize your entire final account balance.
The income amount that you see is what you would get if you used your entire projected final account balance to purchase an immediate annuity. That means giving up your whole nest egg in exchange for a monthly payment guaranteed for as long as you (and possibly your spouse) lives. While that may sound nice, keep in mind that you’re losing the ability to access your money if you need it, invest it to grow over time, and pass the remainder on to your heirs. Annuity payments are also not typically adjusted for inflation each year.
If you decide not to annuitize your entire balance, your projected income would be lower. That’s because studies have shown that you can safely withdraw no more than 4% from a balanced portfolio and increase that with inflation each year without a significant chance of running out of money over 30 years. On the other hand, annuities will generally pay you more than 4% of your principal as income.
For example, $500k could purchase a $2,320 immediate monthly annuity for a 65-yr old couple on this site. (Interest rates will have an impact on your projected future income since the higher interest rates are, the higher annuity payments will be for the same lump sum.) However, withdrawing 4% from that same $500k would produce only $1,666 of income per month.
2) They may be reported in future dollars.
Second, find out if that projected income is reported in today’s dollars. If not, that income amount could be worth a lot less once you take inflation into account. Using the previous example, $2,320 in 30 years is only worth $955 in today’s dollars assuming the average 3% inflation rate. To convert future dollar amounts into present value, you can enter them into this calculator and use a 3% inflation rate for the interest rate. (You can get Social Security projections in today’s dollars but your pension projections may be in future dollar too.)
3) They don’t factor in taxes.
If your account is pre-tax, you’ll have to pay taxes on any withdrawals you take. You can estimate how much of your retirement income will go to federal taxes here. (While this is based on current tax rates, the tax brackets adjust each year with inflation.) You may want to further reduce that by state income taxes as well.
Seeing your retirement plan balance as a future retirement income stream can certainly be helpful in putting the value of your savings in a more useful context. On the other hand, not knowing that the projected income is based on full annuitization, may be in future dollars, and doesn’t factor in taxes can cause you to think your expected retirement income is higher than it really is. That’s a mistake you don’t want to make. After all, the only thing worse than not knowing whether you’re on track is falsely believing that you are.